Part IV: Report and Measure Financial Results

CHAPTER 10:

FINANCIAL & OPERATING RATIOS AS PERFORMANCE MEASURES

The Importance of Ratios

Ratios are important because they are so widely used.

Financial ratios are especially important because they are used for credit analysis.

See Appendix 18-A for multiple examples of financial ratios as used for credit analysis and financing purposes.

The Importance of Ratios3 types of ratios:

Liquidity, solvency, and profitability

These three types include eight basic ratios that are widely used in health care organizations.

Liquidity — current ratio; quick ratio; days cash on hand; days receivables.

Solvency — debt service coverage; liabilities to fund balance.

Profitability — operating margin; return on total assets.

Liquidity Ratios

Current Ratio — A measure of short-term debt-paying ability (but it must be carefully interpreted).

Computed as:current ratio = current assets/ current liabilities.

(Also see practice exercises for this chapter.)

Liquidity Ratios

Computed as:

quick ratio= cash & cash equivalents + net receivables / current liabilities

Quick Ratio — An even more severe test of short-term debt-paying ability (it also must be carefully interpreted).

Also see practice exercises for this chapter.

Liquidity Ratios

Computed as:

DCOH = unrestricted cash & cash equivalents / cash operating expenses / # of days in period.

Days Cash on Hand (DCOH) — Indicates cash on hand in relation to amount of daily operating expenses.

Also see practice exercises for this chapter.

Days Receivables — Represents number of operating days in receivables (a measure of worth as well as performance).

Liquidity Ratios

Computed as:

days receivables = net receivables / net credit revenues / # of days in period

Also see practice exercises for this chapter.

Solvency RatiosDebt Service Coverage (DSCR) — Represents the ability to meet

required debt service (this ratio is universally used in credit analysis).

Computed as:

DSCR = change in unrestricted net assets (net income) + interest, depreciation, and amortization / maximum annual debt service

Also see practice exercises for this chapter.

Solvency Ratios

Computed as:

liabilities for fund balance = total liabilities / unrestricted net assets (fund balances) or (net worth)

Liabilities to fund balance — Represents the relationship of liabilities to fund balance (or liabilities to net worth). A quick indicator of

bad debt.

Also see practice exercises for this chapter.

Profitability RatiosOperating Margin (expressed as a percentage) — Represents the relationship of operating revenues to operating income. A multi-purpose measure, used for many managerial purposes; sometimes also used

for credit analysis

Computed as:

operating margin = operating income (loss) / total operating revenues.

Also see practice exercises for this chapter.

Profitability RatiosReturn on total assets (expressed as a percentage) — Represents the yield

received in relation to total assets. A broad measure in common use.

Computed as:

return on total assets = earnings before interest and taxes (EBIT) / total assets.

Also see practice exercises for this chapter.

Importance of Ratios

Remember, ratio analysis should be conducted as a comparative analysis.

When interpreting ratios, the differences between periods must be considered, and the reasons for such differences should be sought.

Current Ratio

1. Current Ratio

470,000 Current Assets345,000 Current Liabilities= 1.362

Quick Ratio

2. Quick Ratio

190,000+250,000 Cash and Cash Equivalent + Net Receivables345,000 Current Liabilities= 1.275

Days Cash on Hand Ratio

Step 1

1,885,000(40,000)

1,845,0003. Days Cash on Hand (DCOH)

Step 2Unrestricted Cash and Cash Equivalents

1,845,000 Cash Operating Expenses divided by # days in period (365)For the Year Ending 365December 31, 20x2 = 5,055

Step 3

190,0005,055

= 37.5 days

Days Receivable Ratio

Step 1 4. Days Receivables

2,000,000 Percent of Credit Revenuesx 90% Information obtained elsewhere

1,800,000

Step 2 Net Receivables

1,800,000 Net Credit Revenue divided by # days in period (365)365

= 4931

Step 3

250,0004931

= 50.7 days

Return on Total Assets

December 31, 20x2Step 1 5. Return on Total Assets (%)

120,000(20,000)100,000 EBIT (Earnings Before Interest and Taxes)

Total AssetsStep 2

100,000963,000= 10.03%

Operating Margin Ratio

6. Operating Margin (%)115,0002,000,000 Operating Income (Loss)= .0575% Total Operating Revenues

Liabilities to Fund Balance Ratio

Total Liabilities 7. Liabilities to Fund Balance545,000418,000 Total Liabilities= 1.304 Unrestricted Fund Balance

Debt Service Coverage Ratio

Step 1 8. Debt Service Coverage Ratio (DSCR)December 31, 20x2

Change in Unrestricted Net Assets (net income) 120,000 Change in Unrestricted Net Assets (net income)plus Depreciation-Amortization 20,000 plus Depreciation-Amortization

plus Interest 40,000 plus InterestMaximum Annual Debt Service 180,000 Maximum Annual Debt Service

Step 2

180,000 Maximum Annual Debt Service72,000 Information derived elsewhere= 2.5